Is there a simple explanation for why the stock market is plunging so rapidly and inexorably?
There may be. Meet the uptick rule.
A Reuters blog makes the introductions:
The “uptick rule” or “tick test” required short sellers to sell at a price above the last price paid for a stock, or at the price of the stock’s last trade if it was higher than the previous price. The rule had been in effect since 1938, but the SEC removed the rule last year, on July 6, 2007, after saying it was “obsolete.”
The SEC studied its removal, running a pilot program on 1,000 stocks starting in May 2005 through April 2006, a year when the bull market was just getting going and the Standard & Poor’s 500 index rose about 13 percent on its way to record highs. Now that the S&P is down more than 14 percent since the beginning of this year, getting rid of the rule has been blamed for increased volatility, and calls for its return could get louder as the process of market re-regulation gathers pace.
“The SEC did one of the dumb things that has been done to hurt this market, doing away with the uptick rule,” said Don Hodges, president of Hodges Capital Management.
The uptick rule was removed just as subprime mortgages started their meltdown in August last year, which would have been a great time for investors to get short. They did, and short interest has risen to record highs this year.
The uptick rule was designed to discourage speculators from selling short. What is selling short? Basically, a short seller borrows stock from a broker and sells it. When the stock falls, the borrower buys back the shares at a lower price, then returns the shares to the lender and pockets the profit - which can be considerable.
In order for this to work, the stock's price must fall; if it goes up, the borrower will have to buy back the shares at a higher price, and will lose money (sometimes a lot of money). How can the borrower improve the chances that the stock will fall? By spreading malicious rumors about the company (or sector) in question - something that, in the age of the Internet, is easier to do than ever. In some cases the short seller may not need to start nasty rumors, because he has inside information that the stock is going to tank. But in other cases his strategy is to deliberately undermine confidence in a company or a whole group of companies so he can make a quick buck. A concerted attack on a firm is called a raid. For a dramatic depiction, see James Clavell's novel Noble House, which concerns predatory business practices in Hong Kong.
There was no uptick rule in Clavell's Hong Kong - and now there is none in the United States, either.
With no uptick rule in place, selling short is easy, and there is nothing to prevent speculators from systematically raiding one company after another - and, in the process, driving down the whole stock market by creating a climate of panic.
No, short selling isn't the only reason for the market's decline. But it does appear to be a factor, as indicated by an August 9 Reuters article:
A rule change that has made it easier for short-sellers to execute trades may be partially responsible for wild swings in the stock market over the last several weeks.
While the market is also facing considerable headwind from uncertainty over the housing market and the economy, the removal of the restrictive “uptick rule” for short sellers, may be accelerating market declines, analysts say.
“The market move was not caused by the rule change, but there is little doubt that it made the slide occur faster than it might otherwise,” Gregory M. Drahuschak, vice president of Janney Montgomery Scott Inc, wrote in a note to clients this week. “Increased volatility is here to stay as long as the new regulation remains.”
Just yesterday, a prominent corporate law firm issued a call for the return of the uptick rule.
The worldwide securities and credit markets continue to experience unprecedented meltdowns and volatility. Millions of investors are losing their life savings and retirement assets. There continues to be widespread manipulative short-selling and bear raids. The investing public is losing confidence in the integrity of our markets.
For the past five months, we have called on the S.E.C. to reinstate the “Uptick Rule,” which helps limit downward spirals by allowing a stock to be sold short only after a rise from its immediately prior price. Despite widespread market participants’ calls to do so, the S.E.C. has failed to act. The S.E.C. must reinstate the Uptick Rule now to address the short-selling, bear raids, and the spreading of false rumors. Nearly all the reasons that the S.E.C. gave for repealing the Uptick Rule in July 2007 are not valid in today’s turbulent markets. In fact, the very same conditions that led to the adoption of the Rule in 1938 exist today.
Some of the comments appended to the article linked immediately above are worth reading. Consider this one:
The sharks are circling and I am one of them. Until the SEC re-instills the ‘uptick’ rule, guys like me…and there are LOTS of us…will continue to short stocks INTO THE GROUND. It doesn’t even matter what the fundamentals are. Everyone just jumps on board. C and GE today, JNJ and MRK tomorrow. There is no other way to make money in this market.
Whoever wrote this is little better than a domestic terrorist, a conscienceless sociopath willing to destroy the economy and wipe out the life savings of all Americans (and many others around the globe) just to pocket a few dollars for himself. The lapse of the uptick rule has opened the door to such people.
Even the very free-market-oriented Investors Business Daily wants revival of the rule:
Our equity and credit markets are justifiably suffering from a crisis of confidence that touches all securities. The uptick rule was designed to function best in this environment. The Securities and Exchange Commission, one of our most responsible regulating agencies, is weighing re-enactment. It should move promptly.
Note that they were calling for prompt action on September 18. It’s now two months later - and still the SEC , under the "leadership" of Chris Cox, has done nothing.
And the market continues to plunge.
Would the uptick rule reverse the nosedive? Probably not, but it would afford a measure of stability to an increasingly volatile situation.
Restore the uptick rule - today!
This post was adapted from several comments I left at Dirty Harry's Place.